KARACHI, April 10 (Reuters) - Pakistan's chaotic
financial heart is home to 18 million people, Taliban bombers,
contract killers - and one of the world's most successful stock
markets.

With 49 percent returns in 2012, the Karachi Stock Exchange
(KSE) was one of the five best performing markets in the world.
Now it is seeking a foreign partner to buy a stake and take over
management of a market that has risen three-fold over the past
four years.

At least some of that performance came on the back of a
government amnesty that allowed people holding undeclared assets
or "black money" to invest it freely in the market. And the
relatively illiquid market has also been vulnerable to
manipulation.

But government officials say the market's success highlights
the economic potential of a country better known for spiraling
sectarian violence, the war against al Qaeda and the Taliban,
crippling power cuts and entrenched corruption.

The market's benchmark index continues to soar to
record highs -- up 10.34 percent year to date -- fueled in part
by expectations May elections will mark Pakistan's first
transfer of power from one democratic government to another.
Previous civilian governments were all dismissed by Pakistan's
ultimate power: the military.

"Pakistan has a lot to offer investors and this is our
chance to show it," said Nadeem Naqvi, the KSE chairman. He
plans to embark on a series of roadshows for potential foreign
partners that will take him to London, Frankfurt and Hong Kong
in the coming months.

Many of the companies listed on the KSE offer double-digit
returns, low stock prices and resilient business models in this
frontier market with a population of 180 million. The index
still has an attractive price/earnings ratio of $8.50 despite
the soaring returns of the past few years.

Pakistan now has a 4 percent weighting in the MSCI Frontiers
Market Index and has become somewhat of a discovery
for foreign investors chasing new markets and yields.

THE SEAMIER SIDE

But the KSE's spectacular rise last year can at least be
partly attributed to another factor entirely - the cleansing of
"black money".

The market took off last year just as a government decree
was finalized allowing people to buy stocks with no questions
asked about the source of the cash. Average daily volume more
than doubled last year to 173 million shares from 79 million in
2011.

Authorities say the measure will bring undocumented funds
into the tax net in a country where few pay taxes. But some
critics decried it as a gift to corrupt officials and criminals
seeking to launder dirty cash.

"Politics and dirty money go hand in hand in Pakistan," said
Dr. Ikramul Haq, a Supreme Court lawyer and a professor on tax
law.

"People want to be outside the regulatory framework and
outside the tax net."

The black money amnesty also drew attention to the seamier
side of the Karachi stock market. Interviews with regulators,
brokers, market officials and analysts showed insider trading
and other manipulations are routine. Regulators have been
largely ineffectual in controlling the shady practices.

The Securities and Exchange Commission of Pakistan (SECP)
said it found 23 violations of securities laws that merited
fines in fiscal year 2011-12 (April/March). The market regulator
sent warning letters in another 19 cases, it said in its annual
report. ()

That's a drop in the bucket, says Ashraf Tiwana, dismissed
as head of SECP's legal department after years of clashes with
his bosses over fraud in the market. He has petitioned the
Supreme Court to replace the SECP chairman and commissioners.

"There's a lot of fraud, a lot of market manipulation ...
but not enough action has been taken, especially not enough
criminal action has been taken," Tiwana told Reuters. "They're
just passing small fines and giving out warning letters."

Regulators are too close to the market, Tiwana said. The
head of the stock exchange is a former broker and the two top
members of the SECP are former employees of Aqeel Karim Dhedhi,
founder of one of the country's biggest brokerage houses.

BIG DHEDHI

Nicknamed "Big Dhedhi" for his ability to move markets,
Aqeel Karim Dhedhi heads one of Pakistan's largest domestic
conglomerates, the AKD Group.

Lately, the well-known philanthropist and leading member of
Pakistan's business establishment has been trying to fend off
arrest over allegations of insider trading.

An SECP investigator accused traders, including
Dhedhi's brokerage, of buying shares in a state-run Sui Southern
Gas Co before an official announcement allowing the
company to raise its prices. In the weeks before Sui Southern's
announcement, the stock price jumped from 13.5 rupees to 20
rupees, its biggest hike in five years.

The National Accountability Bureau, the state-run
anti-corruption agency, called it a case of insider trading. But
the SECP said its own confidential investigation showed no
evidence of fraud. The SECP whistleblower in the case has been
suspended from her job for disclosing "confidential
information".

Dhedhi strongly denied any wrongdoing and said he purchased
his gas stocks years before the announcement.

"There is nothing there. The (SECP) report totally cleared
us," said Dhedhi, a burly man wearing a traditional long cotton
shirt and baggy pants. "I'm proud to say that in more than 40
years of operating, we've never paid a penny in fines."

Dhedhi says he often offers advice to government officials
on financial policy. His business empire includes two equity
funds that were among the best performing in Asia in 2012.

"The SECP has really started listening to the market,"
Dhedhi said, a suited executive acting as translator.

REVOLVING DOOR

Dhedhi remains under investigation. But even if regulators
were to find him guilty of insider trading, past practice shows
he would likely get a slap on the wrist. The SECP's fines are
almost always a fraction above the amount of money made in the
stock manipulation, and sometimes even less.

In December, a broker was fined half the amount he made from
trades that manipulated the share price of tobacco giant Philip
Morris. In February, the SECP fined Pakistani
brokerage BMA Capital $500,000 - after it made $460,000 by
misleading a foreign client. BMA Capital has appealed.

Imtiaz Haider, the SECP commissioner in charge of market
regulation, acknowledged fines were largely symbolic. If they
were too high, he said, brokers might not be willing to pay
them. Contesting fines in the congested court system could take
years.

"The purpose is more to name and shame," Haider said in an
interview. "It causes them reputational damage."

Like KSE Chairman Nadeem Naqvi, Haider is a former employee
of Dhedhi's. Both men denied any conflict of interest.

"It's important to have people in charge who know the way
markets work," Haider said. "I've had lots of other jobs than
just working for Dhedhi."

The SECP can revoke licenses, impose hefty fines, or open
criminal cases against offenders. But it almost never does. It
has launched only 10 criminal cases in the past five years - all
still held up in the judicial backlog. It has issued dozens of
small fines.

"We have great laws and regulations but they are not
properly enforced," said Khalid Mirza, a former SECP chief. "The
SECP is just catching the small fish as far as I can see."

Naqvi, the KSE head, acknowledged his priority has been to
boost the market, not to crack down on it.

"My management style isn't confrontational because I want to
build confidence in the market," he said.

Separating the commercial and the regulatory functions of
the market is one of the main reasons the KSE is looking for a
foreign partner. It has appointed Deutsche Bank as its advisor
on its quest to demutualise - a process that will separate those
two functions.

"Demutualisation is another step on the road to reform,"
Naqvi said. "Right now we have a fairly robust system. But I'm
not saying its foolproof."

BLACK TO WHITE

The Karachi market's small size and lack of liquidity make
it vulnerable to manipulation. Market capitalization is only
$41.5 billion - the Bombay stock market's
capitalisation is more than 10 times higher at $578 billion.

Only a quarter of the shares are freely floated - about 30
percent of that is held by foreign funds and investors,
including Franklin Templeton, Invesco Ltd, Goldman Sachs Asset
Management and Mackenzie Financial Corporation.

Since only 60 of KSE's 600 listed companies trade regularly,
small trades can rapidly make a big difference in a company's
share price.

Boosting volumes on the exchange was one of the intentions
behind Pakistani President Asif Ali Zardari's decree last April
turning black money into white.

It said no questions could be asked by the Federal Board of
Revenue about the source of funds invested in stocks till July
2014. The investments become legally legitimate.

The pool of such funds is potentially huge. A report by the
United Nations Office on Drug and Crime projected the size of
Pakistan's informal or "black" economy at $34 billion in
2010-11, one-fifth of the formal economy.